9/28/2009 @ 12:01AM

Irrational Exuberance

James Grant, editor of the eponymous Grant’s Interest Rate Observer, recently described himself in the The Wall Street Journal as a “glass half-full kind of fellow.” But despite his reputation as somewhat of an economic bear, Grant believes that the looming economic recovery “will be a bit of a barn burner.”

Basic logic supports Grant’s point of view. Indeed, the negative tradeoff to periods of rising economic health is that businesses and individuals become flabby. Businesses become less careful in their investing and hiring, and in their search for profits they often overpay for questionable investments–think
Time Warner’s
purchase of AOL–while hiring marginally less productive workers.

Conversely, the positive tradeoff in downturns is that struggling companies are forced to sell underutilized assets on the cheap to better managers who will derive more value from the same. In terms of employment, the resulting layoffs that occur during recessions offer rising businesses the chance to hire underutilized and, frequently, talented workers who would have been out of reach in boom times.

And for those still employed, stories of layoffs focus the mind. Fearful of being made redundant themselves, workers step up their productivity in an attempt to avoid unemployment lines. Recessions force us to be more productive and, to paraphrase frequent Forbes columnist Jerry Bowyer, add points to our IQ.

Empirical evidence supports Grant’s view that recovery will be robust. Grant cites MKM Partners chief economist Michael Darda, who in a recent client report noted that the “most important determinant of the strength of an economy recovery is the depth of the downturn that preceded it. There are no exceptions to this rule, including the 1929-1939 period.”

Grant added that “growth snapped back following the depressions of 1893-1894, 1907-1908, 1920-1921 and 1929-1933. If ugly downturns made for torpid recoveries, as today’s economists suggest, the economic history of this country would have to be rewritten.” So while history strongly supports Grant’s basic thesis of powerful economic growth in the future, there’s an argument to be made suggesting that the recovery won’t measure up this time.

The reason for this is basic. The rebounds he cites during the late 19th and early 20th centuries coincided with a dollar that had a definition in terms of gold. Looking at the recovery from the 1920-1921 recession alone, economist Benjamin Anderson observed that amid the downturn, the “gold standard was unshaken” despite the economic crisis.

Grant feels that our recent recession bears “comparison with the slump of 1981-1982.” And while he acknowledges that Ronald Reagan was president then, and that Reagan “stood for free enterprise, free trade and low taxes” versus a President Obama who “stands for other things,” he makes the more intriguing point that Obama’s “policies seem as far removed from Roosevelt’s as they are from Reagan’s.”

All of the above may well be true, but what Grant didn’t stress is the rising dollar’s role in the Reagan recovery. Having hit a high of $875 per ounce in early 1980, gold had fallen a great deal by 1982, meaning the dollar had soared. The dollar’s upswing had a powerful impact on future economic growth due to capital-fleeing commodities and other hard assets that are easy to tax, and into what the late Warren Brookes termed “the economy of the mind.”

Simply put, in periods of strong or stable currencies in terms of gold, capital rises from the ground and other earth-based assets, and finds its way to innovators like
Cisco
,
Microsoft
and
Dell
. Conversely, during weak-currency periods like we’ve had since 2001, capital flows away from the innovators who make us more economically efficient, and moves into hard assets like gold, oil, art and housing. (Notice the largely dormant technology IPO market of the new millennium.)

In that sense, the weak dollar in the aftermath of the 2000-2001 recession explains why voters were never quite convinced by an economic recovery that showed up in gross domestic product and, to a small degree, the stock market. Indeed, as of May 2008, oil companies accounted for 15% of the S&P 500′s value, not to mention that energy companies made up almost half the income growth reported by S&P 500 companies in the first three months of 2008.

The equity and earnings boom of the Bush years occurred mostly within commodity companies that do best during times of dollar weakness. The electorate’s broad unhappiness with the economy during the Bush years wasn’t so much a fiction driven by the liberal media–it had more to do with the fact that most Americans don’t work in energy. For the vast majority of Americans working outside the energy sector, earnings during the Bush years weren’t very robust.

So in trying to divine what economic recovery will look like, it’s useful to look to the 1973-1976 rebound, which occurred when the dollar was low, as well as the alleged “Bush Boom” from 2002-2007. Neither will go down as banner eras of economic growth, and with good reason. Inflation not only erodes the value of the money in our pockets, it drives capital away from the kinds of economic activity that truly drive innovation and efficiency.

Looking ahead, the presumed Obama “snapback” will be burdened by bailouts and other governmental attempts to shield the economy from natural market forces, along with Obama’s very own policies that, while not quite on par with those of FDR, are far from the free-enterprise leanings of Ronald Reagan. If we combine the latter with the Obama administration’s embrace of the very dollar weakness that so greatly harmed the Bush economy, it’s a fair bet that any recovery will not be very broad, nor very powerful.

John Tamny is editor of RealClearMarkets, a senior economist with H.C. Wainwright Economics and a senior economic adviser to Toreador Research and Trading. He writes a weekly column for Forbes.